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Last weekend I decided to review my portfolio and think about what might occur in the market in 2014. I am not a trader, I am a dividend growth investor so I did not look to 2014 in anticipation of trading in or out of stocks. I did this more as an intellectual exercise. I do not believe anyone can consistently predict the market, but I enjoy looking at market history and current market influences to take a guess at what might happen.

This article is a look at market history and the current political and economic influences that I believe will positively affect the market in 2014.

In April, 2012, I wrote this article where I gave a number of reasons why the market was going higher. I received a number of comments disagreeing with me, including my favorite that stated "I must be on reefer". Well I managed to get that call correct, so with a clear mind I venture forth again, to take a guess at where the market is headed.

Last Five Years Returns

With two months to go in 2013 it is quite likely the S&P 500 will close up for the 5th straight year. Over the last five years the S&P 500 has returned, dividends included, 83.32%

YearS&P 500 Return
200927.11%
201014.87%
20112.07%
201215.88%
201323.39%*

Note 1 - 2013 return is as of Friday 10/25. Note 2 - The S&P 500 officially began in 1957, but numerous internet sites have compiled an S&P 500 going back to the early 1900's which I refer to in this article.

What History Tells Us

If you study the history of stock markets you can ascertain patterns that have occurred and/or see economic influences that have consistently affected the market in a certain manner. This does not mean the exact same thing will occur again, but it does provide reference points as you look at current market conditions. Looking at the S&P 500 historical returns, only three times has the S&P 500 had 6 or more straight up years, 1947 through 1952, 1982 through 1989 and 1991 through 1999. All of these periods saw influences from outside forces that pushed the market higher. The 1947 to 1952 period was, of course, the end of the war, the 1980's saw a huge decline in interest rates from the Paul Volker kill inflation high interest rate environment of the 1970's, and the 1990's was the unfortunate dot-com bubble.

The last five years have seen the Federal Reserve engage in an unprecedented zero interest rate and bond buying policy intended to ignite a slow economy and bring down unemployment. The outside influence of the Federal Reserve has driven up stock prices and had some positive effect on the economy. Since the market has had only six straight up years three times in its history, it is safe to say, the odds are against a 6th straight up year. However, never before has the Federal Reserve taken such an aggressive approach to improving the economy. I believe, the Federal Reserve's continued aggressive monetary policy and several other factors I will discuss, will result in another year of positive returns.

Valuation

As of the close on Friday 10/25, the S&P 500 P/E based on trailing 12 month earnings was 18.63, a year ago it was 16.44. Based on estimated next year's earnings it was 15.85. The yield on the S&P stood at 2.02%, a year ago it was 2.10%.

Assuming earnings continue to grow as they are forecast to, the market is reasonably priced. The market is not cheap, but it is also not wildly overvalued. Earnings, as they always are, will be key. If the economy were to pick up steam, stock prices would be relatively cheap, if the economy slows down and earnings stagnate or decline, the market would be expensive.

For the almost completed 3rd quarter earnings season, the earnings per share of $26.85 is on track to establish a new quarterly and trailing four-quarter high. In addition, the trailing four-quarter earnings per share totals $102.13. Earnings have steadily been rising quarter over quarter.

For 2014, both Barclays and Citigroup (NYSE:C) have raised earnings forecast for the S&P. Barclays sees EPS of $114.00 and Citi sees EPS of $116.25. Put a conservative P/E of 16 on those earnings and you get an S&P of 1,824 and 1,860 respectively. The S&P, as I write this, stands at 1,763

Interest Rates

When 2013 started, I thought for sure interest rates would rise during the year and the Fed would reduce their quantitative easing. I was wrong. However, that will not stop me from predicting interest rates will rise in 2014. In my opinion, if it was not for the Congressional budget/debt ceiling fight, the Fed may have announced their taper plan at the August Fed meeting. Deciding to err on the side of caution, the Fed put off the taper announcement and interest rates again fell. However, I expect the taper plan is just on temporary hold until early 2014.

So will rising interest rates kill the stock market rally? Not necessarily. Doug Ramsey, Chief Investment Officer at Leuthold Group, a Minneapolis investment research firm, found that stock prices and bond prices often rise in tandem, especially when starting from a low yield. Since 1955, bond prices and stock prices have risen simultaneously about 1/3 of the time.

In 2013, interest rates did rise for a short period when the bond market anticipated the Fed would slow its bond buying. When the Fed decided against tapering, rates again headed back down. However, it should be noted, that during the summer when the 10 year yield rose from 2.03% on May 22nd to 2.96% on September 9th , many income stocks like REITs, utilities and MLP's fell hard. I would look for that to occur again, if rates rise.

The chart below shows the price movement for two widely held utilities, two REIT's and one MLP. As you can see, as rates rose, stock prices fell. REIT Prices fell especially hard, something that REIT investors should be aware of if interest rates in 2014.

CompanyPrice 05/22Price 09/09
Southern (NYSE:SO)$45.76$41.23
Duke (NYSE:DUK)$70.19$65.57
Realty Income (NYSE:O)$52.41$39.96
Ventas (NYSE:VTR)$80.71$62.16
Enterprise Products (NYSE:EPD)$63.09$59.15

Bond Market Outflows

If I am right about interest rates rising, then it is highly likely bond funds and ETFs will see outflows of cash and some of that money will go into stocks. In June of this year, when interest rates were rising, bond fund outflows hit record levels and flows into stocks funds exploded higher. After the Fed announced they were not tapering, money went back into bonds and the bond market rallied. If interest rates rise, as I think they will in 2014, that will be a net positive for the market as some of that money will flow into stocks.

Help From Our Friends

The 2008 financial crisis hit the world economies hard, some economies came back faster than others, The European economies have been very slow to recover, but have shown signs of late that things are improving. Chris Williamson, Markit's chief economist, noted, "The growth trend is a modest one but the expansion is reassuringly broad-based across the region, reflecting signs of economic recoveries becoming more entrenched in the periphery as well as ongoing expansion in Germany and stabilization in France."

Many of the multi-national companies in the S&P 500 would benefit from an improving Europe. Companies like Coca-Cola (NYSE:KO) and Kimberly Clark (NYSE:KMB) have reported slow sales in Europe.

Coca Cola CEO Muhtar Kent stated "Moving on now to Europe, we again witnessed diverging results with 3% volume growth in Northern European countries, offset by a 5% volume decline in countries that make up Central and South Europe for a net decline of 1% in our European business in the third quarter."

Kimberly Clark stated in their 3rd quarter earnings press release "Except Europe, regions of North America and K-C International witnessed increase in sales. Sales in Europe were flat in the quarter."

An improving economy in Europe would give a boost to multi-national companies that have a presence in Europe.

The Japanese government and central bank are making a concerted effort to pump some growth into the Japanese economy, which would also be beneficial for many S&P 500 companies. Japan's plan, consists of further easing, combined with more government spending on economic stimulus, hopefully pushing up prices to end years of deflation, and leading to more robust growth for the world's third largest economy. This plan has begun to see results as the Japanese economy grew 2.6% in the 3rd quarter.

Like with Europe, an improving Japan in 2014 would be beneficial for the S&P 500 companies that do business in that country.

The world economy is intertwined in a way that, in general, what is good for one country is good for all and what is bad for one country is bad for all. An improving world economy would be good for the stock market, especially the multi-nationals. As I look forward to 2014, I see the world economy, especially Europe, continuing to improve. However, I also know that unknown events could change that tomorrow.

Inflation

As we sit here today, inflation is nowhere in sight. However, there are those that believe with the Fed's foot on the gas pedal it is only a matter of time before inflation kicks in. So the question becomes, if inflation does kick in, how will it affect the stock market?

Various studies have shown that the best real (adjusted for inflation) S&P 500 returns occur when inflation is between 2% and 3%. Inflation greater than or less than the 2% to 3% tends to show the U.S. macroeconomic environment is having issues.

We sit just below the 2% to 3% inflation rate today, as the September report showed an annual inflation rate if 1.2%. There is nothing on the horizon that would indicate a rapid increase in inflation. Energy prices have been coming down, the crop yields this year in the United States, Brazil and other countries have been bountiful and wages, the greatest cause of inflation, have been kept in-check. With inflation at 1.2%, even if inflation doubled next year, we would still be in the 2% to 3% window where markets perform best. For 2014, inflation remains, only a slight risk.

Politics

As we have seen all too frequently in recent years, the politicians in Washington can disrupt the market with their brinkmanship shenanigans. 2014 is mid-term election time and in most cases the politicians do not do anything foolish in an election year. They hope you forget all the silly things they did in the previous year and vote to re-elect them. Since the government shut-down, the tone out of Washington has been a little more conciliatory, which should continue into next year. With congressional approval ratings at all-time lows, I don't think with an election on the horizon we will see any political upheaval from Washington in 2014.

For the record, I researched historical studies that looked at stock market returns in mid-term election years. There are many of one type or another, some look at the four year presidential cycle and some look strictly at the mid-term election years. Results varied with no consistent pattern shown. In general, as this study shows, stock market returns are better after the mid-terms than before.

So Where Does All This Leave Us?

When looking at all the above factors that can affect stock prices, none of them, with the possible exception of rising interest rates, appear likely to disrupt the upward move in stock prices. In fact, I believe the rising interest rates and bond fund outflow scenario will be beneficial to stocks, with the possible exception of income stocks like REITs and utilities. Earnings as always, will be key, as long as earnings continue to improve, stock prices will move up. With Europe slowly improving and other parts of the world growing I believe it is highly likely earnings will continue to grow as they are forecast to. Aiding this rise in earnings is the fact, companies are buying back a record amount of shares. Fewer shares makes it easier to grow your earning per share.

The late Marty Zweig, a frequent "Wall Street Week with Louis Rukeyser" guest , used to always say "Don't fight the Fed." and "Don't fight the tape." That advice is often repeated, but often ignored. There is no doubt we are in an upward tape, but some have declared the Fed tapering policy will be a tightening. I do not see it that way as the Federal Reserve has signaled they will keep interest rates near zero through late-2015. No matter how you color it, zero interest rates are an accommodative policy and will be positive for the stock market.

I am not a market forecaster and I actually believe no one can predict the market. However, as investors, it behooves us to look into the crystal ball and make intelligent assumptions on what future market conditions will be. While also being ready to change those assumptions on a moment's notice based on data or events. Based on everything I looked at, I believe 2014 will be another positive year for stock market returns.

Source: Why 2014 Will Be The 6th Straight Up Year For Stocks